Transfer pricing Case 18.3

1. Transfer pricingCase 18.3 Priyanka Tyagi Shalini Singh Madhuri Chakraborty Jisha Nambiar Jinashree Rajendrakumar

2. Explain Foreign Sales corporations ? • Foreign sales corporation, a subsidiary of a U.S. corporation that is established offshore to handle foreign sales. • The U.S. tax code allows a tax exemption for exports generated by a FSC. • An estimated 3,600 companies, including Boeing, Microsoft and General Motors, have set up such subsidiaries in tax havens such as the U.S. Virgin Islands • FSCs can be formed by manufacturers, export intermediaries, or groups of exporters. • FSC can function as principal, buying and selling for its own account, or as a commission agent.

3. Formation Requirements : • The entity must be incorporated and have its main office in the U.S. Virgin Islands, American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, or a qualified foreign country • It must have at least one director who is not a U.S. Resident. • It should not have more than 25 shareholders. • It should not have any preferred stock. • The FSC also cannot be a member of a group which includes a Domestic International Sales Corporation. • The foreign corporation must make an election to be taxed as an FSC. Ref: 1. http://www.lectlaw.com/files/buo05.htm 2. http://library.lp.findlaw.com/articles/file/00337/005239/title/Subject/topic/Taxation--%20Federal_Income%20Taxation-%20Income%20Taxable/filename/taxation--federal_2_5806

4. Nature of the benefits to U.S exporters • Income tax benefits under the discontinued Domestic International Sales Corporations (DISC) rules have been reincarnated, with greater benefits, under the Foreign Sales Corporations (FSC) [1] • FSC rules are in Internal Revenue Code sections 921 through 927 and the corresponding regulations. • FSC helps to shift what would otherwise be a taxable export profit to a distributing FSC where only a portion of the profit is taxed. • The US exporter’s tax rate on overall profit reduces since the FSC is closely held by the exporter as shareholder. • US exporter can reduce federal income tax on export-related income • The tax exemption can be up to 15% on gross income from exporting. At 35% corporation tax rate companies can keep 5.25% more of their revenue. [2] • References: • Vocovec, Mayotte & Singer (1999) Foreign Sales Corporations. Website: http://library.lp.findlaw.com/articles/file/00337/005239/title/Subject/topic/Taxation--%20Federal_Income%20Taxation-%20Income%20Taxable/filename/taxation--federal_2_5806 • http://www.lawandtax-news.com/html/us/juslatcorp.html

5. Conditions for exempt income of U.S exporters • There are 2 economic process requirements to earn income exemption from tax for any export transaction [1] • a transaction is any sale, lease, or furnishing of services • FSC, or its agent, must participate, outside the U.S., in any of the following in export transactions: 1) solicitation (other than advertising), 2) negotiation, 3) contracting • Specific % of the transaction costs must be "foreign direct costs," incurred by the FSC for activities performed outside the U.S [1] • foreign direct costs incurred by the FSC must equal or exceed 50% of the total direct costs of the transaction (5 activities) [2] 1) Advertising and sales promotion; 2) Processing of customer orders and delivery of export property; 3) Transportation of goods from the time of acquisition to delivery; 4) Final billing and receipt of payment; or 5) Assumption of credit risk. • 85% or more of direct costs incurred in each of any two of the five activities • References: • http://www.lectlaw.com/files/buo05.htm • Vocovec, Mayotte & Singer (1999) Foreign Sales Corporations. Website: http://library.lp.findlaw.com/articles/file/00337/005239/title/Subject/topic/Taxation--%20Federal_Income%20Taxation-%20Income%20Taxable/filename/taxation--federal_2_5806

6. Nature of the benefits to U.S exporters • The sources and types of income which actually comprise a US exporter’s foreign trade income must be one of the 5 types of Foreign Trading Gross Receipts (FTGR) [1] • The sale, exchange, or other disposition of export property • The lease or rental of export property for use outside the U.S • Services related to a sale or lease of export property • Engineering or architectural services on projects outside the U.S • Managerial services for an unrelated FSC or DISC in support of its foreign trade. • No other type of gross foreign trade income qualifies as FTGR and, accordingly, cannot qualify as tax exempt income. • References: • 1. Vocovec, Mayotte & Singer (1999) Foreign Sales Corporations. Website: http://library.lp.findlaw.com/articles/file/00337/005239/title/Subject/topic/Taxation--%20Federal_Income%20Taxation-%20Income%20Taxable/filename/taxation--federal_2_5806

7. Nature of the benefits: Methods for calculating tax exempt income • Arm's length prices method- assumes the prices paid by the FSC for goods from its related U.S. supplier = true fair market value. [1] • foreign trade income exempt from U.S. taxes under the FSC rules is set at 32% for individuals and 30% for corporations. • remainder of the FSC's foreign trade income falls outside the scope. • Statutory formula method - offers 2 options for allocating foreign trade income between the FSC and the U.S supplier. [1] 1. Based on FSC's gross receipts : gross income rule • Based on combined taxable income of the FSC and the related U.S. supplier: combined taxable income rule • foreign trade income = 1.83% of the FSC's gross receipts from the sale of export property. Limited to a maximum of 46% of the combined taxable income of the FSC and the U.S. 15/23 (approx 65 per cent) of the FSC's foreign trade income is exempt from US tax. Thus, exemption is up to 30 per cent (46% x 15/23) of the total combined taxable incomeor 1.2% of gross receipt • Foreign trade income = 23% of the combined net taxable income of the FSC + related U.S. supplier from the sale of export property : 15/23 (approx 65 per cent) of the FSC's foreign trade income is exempt from US tax .ie. 15% ( 15/23 x 23%) • References: • Vocovec, Mayotte & Singer (1999) Foreign Sales Corporations. Website: http://library.lp.findlaw.com/articles/file/00337/005239/title/Subject/topic/Taxation--%20Federal_Income%20Taxation-%20Income%20Taxable/filename/taxation--federal_2_5806 • http://www.law.georgetown.edu/iiel/cases/US-FSC(panel).pdf

8. Why have corporations in the European Union disputed the existence of these corporations?

9. US and EU • US and EU economically interdependent • EU one of the top two markets for the US. • 40 % of US investment abroad and 20 % of US exports goes to the EU • The EU is source of 50 % of foreign investment in the US. • Up to 3 million highlypaid jobs in the US are due to EU investment. http://www.lowtax.net/lowtax/html/offon/usa/usacorp.html

10. Why EU disputed US FSCs? • U.S. tax laws not in compliance with WTO rules • US violates the SCM Agreement - a “subsidy” exists if “government revenue that is otherwise due is forgone or not collected.” • Illegal subsidies benefits US corporations - US corporations kept 5.25% more of their revenue • Fierce competition in key sectors • Amount of subsidies granted is substantial - In 2000, subsidies of $4 billion according to the US Budget proposal. http://www.mindfully.org/WTO/EU-WTO-Sanctions-US.htm http://www.lawandtax-news.com/html/us/juslatcorp.html

11. The story so far… • Nov 2000, FSC replaced by the Extraterritorial Income Exclusion (ETI) • With ETI Act export subsidy scheme still existed • EU challenged it before the WTO • Jan 2002, the WTO confirmed that the ETI Act constituted prohibited export subsidy • May 2003, the WTO endorsed the EU for counter-tariff of US $ 4 billion • The EU, set 1 March 2004 as deadline for the US Administration and Congress to repeal ETI.

12. The story so far… • May 2003, short-term substitute for the ETI legislation introduced • March 2004, EU imposed a counter-tariff on US goods starting at 5% • As of mid-2004, it remains to be seen what bill will emerge from the reconciliation process.

13. Transfer pricing Definition : The determination of an exchange price when different business units within a firm exchange products or services. Alignment with SBU management • Affects strategic objectives of firm (value chain decision) • Requires coordination among various functions. • Determination of transfer price is desirable from a management perspective and tax purposes. • Minimize taxes locally and internationally

14. Transfer Pricing Methods • Variable cost – sets the transfer price equal to the variable cost of the selling unit. • Full cost – sets the transfer price as the variable cost plus allocated fixed cost for the selling unit. • Market price – Set the transfer price as the current price for the selling unit’s product in the market. • Negotiated price – involves a negotiation process and sometimes arbitration between units to determine the transfer price.

15. Role of FSC in transfer pricing • A portion of the income of a foreign sales corporation (FSC) is exempt from tax. The exemption is available with respect to income allocated to the FSC under special transfer pricing rules. • Concerns about FSC avoiding US taxes prompted IRS tools to enforce tax assessment and collection against foreign companies and to provide greater penalties for companies understating U.S. tax liabilities. These regulations are “Transfer Pricing” provisions. • The transfer pricing provisions authorize the IRS to reallocate income, expenses and deductions amount related organizations, trades or businesses in order to “prevent the evasion of taxes or clearly to reflect the income of any such organizations trades or businesses”. • The transfer price is used to allocate foreign trading gross receipts from the sale of export property or from certain services between the FSC and its related supplier

16. Role of FSC in transfer pricing • The transfer prices are based on either of two optional administrative pricing rules or the arm's-length pricing rule • Under the administrative pricing rules, transfer prices such that the FSC taxable income will not exceed the greater of (i) 23 percent of the combined taxable income of the FSC and its related supplier or (ii) 1.83 percent of the gross receipts derived from the sale of property by the FSC. • The arms- length standard sets transfer prices to reflect the price independent parties would have set • The difficulty with transfer pricing is determining what is an “arm’s length fair fee”, particularly in the absence of a third party willing to perform exactly the same activity.

17. Management Accountant’s responsibility regarding FSCs • A company subject to tax in more than one jurisdiction compounds management's responsibility. • Tax-planning strategies must be applied to taxes in each jurisdiction. Plus, it is entirely possible that the strategies will conflict. • Management Accountant should find a strategic balance among these conflicting objectives(E.g.: Custom charges, currency restrictions, expropriation etc) • Management Accountant should determine the proper transfer price, which minimizes taxes locally and internationally. • A task force comprising financial accounting, tax, and other management personnel is needed to develop its strategies. • The task force must ensure that the data for calculating deferred taxes is gathered efficiently.

18. Deferral & Temporary Differences • Deferral - The period between the earning of income by the subsidiary and the transfer to US parent of a dividend is called “deferral”. • The difference between taxable income and accounting income occurs from 2 sources 1. Permanent differences – Items of revenue, expense, gain or loss that are reported for accounting purposes but never enter into the computation of taxable income. 2. Temporary differences- wherein an item of revenue, expense, gain or loss arises in determining accounting income in one period and for taxable income in another period.

19. Contd… • For temporary differences whose reversal periods cannot be determined objectively (e.g., warranties, bad debts), procedures for building an experience base that will guide the allocation of amounts to future periods may be necessary. • A procedure for monitoring and evaluating proposed or enacted changes in each tax jurisdiction may be needed as changes in the laws have an immediate, direct effect on the deferred tax provision in SFAS 96. • The SEC staff has indicated that, in its view, intent or lack of intent should not be allowed to justify the management of reported results. • If the facts were not available when the statements were published, retroactive restatement would seem inappropriate. Reference: 1. Tax-planning strategies for SFAS 96. (Statement of Financial Accounting Standard) by McGrath, Neal T - http://www.nysscpa.org/cpajournal/old/07916798.htm

20. Questions?